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Conformity Becomes a Growing Concern at American Funds

As the family's assets balloon, advisors should be on the lookout for fund overlap.

Greg Carlson, 11/03/2008

In a choir, it's important to have everyone singing from the same hymnal, but that isn't true when you're selecting funds for a portfolio.

Many investors take care to cover different areas of the equity and bond markets to help smooth out the ride as stocks and bonds move in and out of favor. To help do the job, clients and their advisors often turn to the offerings of American Funds. The past 10 years have seen enormous growth in assets at American Funds. In general, performance of the firm's funds has remained strong, but as American's funds have grown, we wondered whether there is now greater overlap between the funds.

To find out, we examined the correlation of returns between pairs of funds from separate Morningstar categories, using R-squared. We also compared those changes in correlation with the changes for broad Morningstar fund categories. Finally, we looked at the rise in foreign stakes at some of American's domestic-equity funds and how that has affected the way that they act relative to the firm's foreign- and world-stock funds.

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This exercise should help advisors avoid pairing those funds that look and act alike. It can also shine a light on the effects of the massive increase in assets at the funds; that increase may cause the funds to own more of the same stocks and employ more of the same managers (in order to spread the money around). It's important to keep any such changes in context, as the roller-coaster ride of the equity markets over the past 10 years has resulted in different types and sizes of companies becoming more attractive to managers of certain stripes.

More of the Same
First, let's tackle holdings overlap. We examined the overlap between each of American's three large-value funds--American Mutual AMRMX, Investment Company of America AIVSX, and Washington Mutual AWSHX--and each of its large-growth funds--Amcap AMCPX, Growth Fund of America AGTHX, and New Economy ANEFX--as of December 1997 and December 2007. In all but one case, overlap between each of American's large-value and large-growth funds increased by a double-digit percentage of assets (an average of 20% of assets).

The biggest increase was between Washington Mutual and Growth Fund of America, from 3% of assets to 31%. Given the difference between the funds' objectives, that increase is rather eye-opening. Washington Mutual focuses on firms that pay healthy dividends and avoids those that garner the majority of their revenue from alcohol or tobacco. Growth Fund favors firms that churn out steady earnings growth or are in the midst of a turnaround.PAGEBREAK

Two developments help explain the funds' rising overlap and the increasing overlap between American's large-value and large-growth funds in general. First, after the late-1990s bull market run of growth stocks and value stocks' ensuing seven-year rally, valuation disparities between value and growth stocks have shrunk. There are fewer definitive bargains out there, so funds with different objectives--supported, to some degree, by the same analyst staff--are more likely to find the same stocks attractive. Second, there has been an influx of managers at these and other American funds. Because of the dramatic increase in assets, almost all of American's funds have more portfolio managers at the helm than they did 10 years ago. With more managers overseeing more assets, nearly every fund owns a greater number of stocks.

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Washington Mutual is an exception to this trend: It's run by seven managers, the same number that it had a decade ago, and it owns slightly fewer stocks despite a far larger asset base. Growth Fund of America, however, now has 11 managers (compared with six in 1997) and holds 280 stocks--double what it held 10 years ago. So the overlap between these two funds is partially driven by Growth Fund's rapidly expanding asset base (close to $200 billion at 2007's end). Growth Fund's overlap with American's other two large-value funds has also sharply increased over that period.

On the other hand, Growth Fund's overlap with fellow large-growth offerings Amcap and New Economy has dropped slightly. This highlights the other reason Growth Fund looks more like its value-oriented siblings: Its managers have found compelling buys in traditional value sectors such as energy, which has resulted in excellent relative returns over the past decade as value stocks have mostly thrived.

Converging Returns
This increased overlap appears to have had an effect on the correlation between the funds' returns. We compared the correlations of the three-year returns of the three large-value and large-growth funds with each other for the periods ending December 1997 and December 2007. Although most of the funds didn't see the correlation between their returns increase significantly over this period, they were more closely correlated over the past three years than the typical large-value and large-growth rivals. (That's because large-value and large-growth funds moved less in concert over the previous three years than they did in the three years ending in December 1997.)

One of American's funds that bucks this trend is Washington Mutual. Its correlations with each of American's large-growth funds are below-average relative to the correlations of the broader categories. The fund's R-squared measures with Amcap, Growth Fund of America, and New Economy for the three years ended in December 2007 were 0.69, 0.69, and 0.63, respectively (1.00 is perfect correlation). Meanwhile, the R-squared of the typical large-value fund with the typical large-growth fund over the same period was 0.72. That distinctiveness is one reason why Morningstar analysts have made this fund an Analyst Pick.PAGEBREAK

As for Growth Fund of America, changes in size and its managers' preferences are the main factors behind its higher return correlations. It's difficult to say to what degree each factor has played a part, but advisors should keep these factors in mind when constructing an American Funds portfolio. Growth Fund has recently been less of a diversifier than it had been. The more-sprawling portfolio means that it's likely to significantly overlap with its large-value siblings--which can lead to higher correlation.

American Goes Globe-Trotting
During the past 10 years, American has given three domestic-equity funds more opportunity to buy into overseas markets. Fundamental Investors ANCFX, Growth Fund of America, and New Economy all had much bigger stakes in foreign stocks at the end of 2007 than they did in December 1997. For example, New Economy's non-U.S. weighting jumped to 35% of assets from 23% a decade earlier. American amended the fund's prospectus to allow for this increase. Meanwhile, American's four more-sedate domestic-stock funds--Amcap, American Mutual, Investment Company of America, and Washington Mutual--have seen little change to their foreign weightings.

As foreign stocks outpaced domestic stocks by hefty margins in recent years, American's three more-opportunistic funds have thrived. To be sure, each of American's seven domestic-stock funds boasts solid long-term records. But the five-year relative returns of the three adventurous funds beat those of each of the four staid funds. Their 10-year relative returns beat those of three of the four U.S.-heavy funds.

It should come as no surprise that the returns of the opportunistic Fundamental Investors, Growth Fund of America, and New Economy correlate more strongly with those of American's world-stock and foreign-stock funds for the three years ended in December 2007 than they did for the three years ended in December 1997. On average, however, these correlations didn't increase to a greater degree than did the returns of the typical domestic large-cap fund to the returns of the typical world-stock or foreign large-cap fund. As the world economy has become more connected, large firms in different countries have seen more similarity in stock-price movement. Still, pairings to avoid are Growth Fund of America and New Perspective ANWPX, and Fundamental Investors with either New Perspective or Capital World Growth & Income CWGIX.

As for Amcap, American Mutual, Investment Company of America, and Washington Mutual--American's more-staid domestic-stock funds--the correlations of their returns with their international siblings' was relatively flat or decreased over the same three-year periods. This makes sense, because each of the world-stock funds was invested more heavily overseas in December 2007 than it was 10 years ago.PAGEBREAK

There is one exception: Smallcap World SMCWX. Each of American's domestic-stock funds has had returns correlate much more highly with those of Smallcap World over the recent three-year period than the three-year period ending in 1997. Now, Smallcap World has a bigger stake in mid- and large-cap firms than it did a decade ago. Chalk that up to the fund's large asset base, which has forced it to buy larger firms, and those firms' attractive valuations, which have drawn attention.

What We Learned
Investors have piled money into the American Funds in recent years, and with good reason. Despite the influx of cash, the fund shop still earns solid returns for shareholders. But to handle all the assets, American has added managers, which in turn has led the funds to owning more stocks than they did 10 years ago. Overlap between American's funds was bound to increase, as our study shows.

Advisors and their clients who rely on American Funds to meet their asset-allocation needs should favor the family's most distinctive funds. Offerings such as Washington Mutual and Fundamental Investors should be the most beneficial to the risk-adjusted returns of investors' portfolios. Funds that are the most vulnerable to asset bloat and ought to be closed--such as Growth Fund of America and Smallcap World--have had a harder time staying distinctive. Advisors using these funds should make sure that overlap has not become a burden on performance.

Greg Carlson is a mutual fund analyst with Morningstar and editor of Morningstar's American Fund Family Report, a monthly newsletter devoted to analyzing the family's funds. 

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